The scenario in the oil market - dwindling supplies, an increasing marginal cost of extraction, and surging demand fueled by increased per capita consumption from developing economies - is being replicated in the industrial metals market. Bond and Snowdon look at supply data for five base metals (copper, zinc, nickel, lead, and tin), showing that known supply (technically defined as the “reserve base”) ranges from 23 to 38 years at current demand levels, a result they characterize as “suggestive of distinct scarcity.” As with oil, estimates of additional hypothetical supply vary widely and are many times greater than the reserve base, which may ease pressure on the market, but these supplies will almost certainly have higher marginal extraction costs.
On the demand side, using copper as an example, Bond and Snowdon show that a rise in per capita Chinese consumption to levels of other industrialized Asian economies (Taiwan, South Korea, and Japan) would push Chinese demand to 177% of current global production. Making the same assumption for Indian consumption pushes the combined Chinese and Indian demand to 2.5 times global production, exhausting the reserve base of copper supplies in less than a decade.
Bond and Snowdon estimate it will take ten to twenty years for Chinese demand to reach the levels of other Asian economies. Indian per capita consumption is lower than in China (e.g., oil consumption is 40% of Chinese levels) and growing at a shower rate. But they claim “competitive pressure in the Asian region” could push demand in India to higher growth rates.
Copper prices, as with many other commodities (including oil) are now at inflation-adjusted prices comparable to levels in the early 1970s. However, this increase in real prices has not stimulated an increase in supply. Real prices began their rise in 2002, and we believe it is premature to conclude that market forces will fail to stimulate additional supply. Bond and Snowdon disagree, describing the situation as one where “yield from exploration efforts is decline, a condition compatible with the idea that the most easily exploitable and fruitful raw material deposits have either already been exhausted or are already in production.”
Ecological and social factors will ultimately mitigate price increases stemming from supply-demand imbalances in the commodity prices. Per capita energy consumption dropped in developed economies as a result of the 1970s energy crisis, and there is evidence the same is happening now. Compromises in our standard of living, from driving smaller cars to resetting thermostats, spurred by ecological degradation from resource consumption, will dampen per capita consumption.
Implications for Advisors
For advisors, Bond and Snowdon believe the inevitable outcome with be a rationing of commodity supplies through higher prices, saying that “the outlook is reasonably clear, favoring a lasting secular rally in real natural resource prices.” Cyclical effects, including the current economic slowdown, will soften prices, but “the long-run trajectory for raw material and energy prices is firmly upward.”
More specifically, Bond and Snowdon offer six predictions for global economies:
- Rising commodity prices will be inflationary on a global level, and higher interest rates will result in lower P/E ratios in all markets, as compared to the last 20 years
- Inflationary pressure will increase volatility in output, growth, and employment.
- In response to this macroeconomic volatility, the risk premia embedded in the equity markets will increase. Investors will require higher returns for an increased level of risk, creating downward pressure on prices.
- Increasing interest rates will force households to reduce their debt levels. This de-levering may reduce per capita consumption levels and decrease the strain on natural resources. The United Kingdom, where Barclays is based, has the highest household debt in the world, according to a recent New York Times article.
- The natural resource sector will receive an increasing share of economic activity and investment.
- Certain industries are likely to suffer. Auto manufacturers will continue to struggle unless they adapt to higher oil prices, tighter regulation, and shifts in consumer taste toward more efficient cars. Airlines may be the biggest losers, with the demand for air travel reducing as higher oil prices are passed on to customers.
The classic argument against commodities, as an asset class in a portfolio, is that, unlike businesses, they do not generate intrinsic cash flow. For most of the last 40 years, the empirical data supported this view, and commodities offered returns roughly paralleling inflation, with trading driven by speculation and short-term demand-supply imbalances. We concur with Bond and Snowdon, and believe the next 40 years will be a lot different. Growth in developing economies will create resource scarcity in many commodities, and advisors with long term time horizons should adjust their asset allocation models to take advantage of these dynamics.
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